Don’t put off until tomorrow what you can do today: When and how you should start saving for a pension

Most experts say you should start putting money into a pension as soon as you begin earning, but the reality isn't so straightforward.

What with paying off credit card and student debt, putting aside a little something each month to build up savings, or dreams of getting onto the property ladder for the first time, saving for retirement can easily be pushed further and further down the list of priorities.

But the enormity of the task ahead shouldn't be underestimated, with the help of pension provider Aviva’s head of policy John Lawson, we run through what you need to know about saving for your nest egg

He lays out the figures: 'For a couple on average earnings of £26,000 (total £52,000) a year, a target of two thirds of final earnings including state pension is realistic – which is roughly £35,000 between them.

'New state pension will deliver roughly £7,500 each leaving another £20,000 to fund. You will need a pot of roughly between £300,000 and £600,000 to provide that depending on whether you go for a level pension or an index-linked one.'

How should you prioritise your savings?

The first thing you need to consider before starting a pension is your financial position.

Usually your employer will offer a scheme that matches your contributions, so if you're thinking of staying put for a while it's probably worth joining up, or else you are effectively turning down extra pay.

However, if you are carrying any form of expensive debt other than a mortgage, you should pay that off before you start worrying about a pension, regardless of what age you are.

I CHOSE TO INVEST FOR MY FUTURE

Chiropractic student Laura Pilbeam, 22, pictured above, opted to start early on an investing career and has seen her portfolio leap by 17 per cent after opening a stocks and shares Isa.

After graduating Miss Pilbeam expected to be self-employed and is keen to build her own pension pot.

'I know that it is crucial to invest for my future, especially with the economic climate the way it is, so I have started to invest in the stock market with a relatively low risk, longer term view,' she explained.

Read more about investing for your retirement below.

That's because most short-term debt, such as personal loans or credit cards, charge a lot more in interest than you could ever hope to make by investing. So you might want to pay that off first.

Also, it's sensible to have at least three months' salary saved as an emergency fund in an accessible bank account so if worst comes to worst you have something to fall back on.

As Lawson puts it: 'Saving money involves prioritising the things individuals need in their lives, whether it is the weekly food shopping, a home, children’s educational needs or retirement planning.

'These short, medium and long-term priorities need to be balanced so that individuals have what they need to cover their daily expenses, manage their debts and also plan for the future. In the end, it is the individual that needs to decide what is most important to them and how they should spend their money.'

So when should you start saving for a pension?

Clearly, if you are financially stable, the golden rule is the earlier the better.

With increasing life expectancy, the younger generation will live longer and work longer. And despite changes to the state pension, it alone is unlikely to provide enough income in retirement.

And remember, for every year you put off saving into your pension, the more you will have to fork out during the latter years of your working life.

Lawson explains: 'The effects of compound interest on pension investments make it particularly worthwhile for people to start saving into a pension as early as possible.

'For instance, if an individual chose to invest £1000 in a pension at age 30, with 35 years of investment growth at 4 per cent per annum it would result in £3,950 at age 65.'

Savings: At what point do you need to start thinking about your future nest egg?

Why can't I just rely on the state pension?

The level of the new combined state pension is expected to be around £148 per week when it is introduced in 2016.

However, some workers may end up paying more in national insurance contributions, and, with changes in life expectancy, all workers will have to work longer before they can access State Pension.

Lawson explains: 'Assuming life expectancy increases as it has since 2000, and this is then reflected in changes to the state pension age, someone that is today aged in their late teens to mid-20s is likely to be in their mid-70s before they can access their state pension – which really means that people need to think about additional retirement saving.'

FINAL SALARY SCHEMES VS DEFINED CONTRIBUTIONS

A final salary pension scheme is one that promises to pay out a certain sum each year once you reach retirement age.

This is normally based on the number of years you have paid into the scheme and your salary either when you leave or retire from the scheme (final salary), or an average of your salary while you were a member (career average). Final salary pensions are now extremely rare because they are not cost effective.

In contrast, with a defined contribution scheme, workers pay in a percentage of salary, typically matched or more than matched by employers, and they must rely on investments for their pot to grow.

On retirement they can take some of their pot as a tax-free lump sum and the rest is usually used to buy an annuity, which is a product guaranteed to pay an income for life.

How do you actually save for a pension?

Saving for retirement is being transformed in the UK with the automatic enrolment scheme, which began in October 2012. During the next few years, millions of UK employees will be automatically enrolled into a pension for the first time without them having to do anything.

What is auto-enrolment?

All employees in the UK who are eligible will be automatically enrolled into a pension over the next few years. Those eligible:

Are at least 22 years old;

Have not reached state pension age;

Earn more than a minimum amount (currently £10,000); and

Work, or usually work, in the UK (under their contract).

Lawson says: 'The employee does not have to do anything as their employer will make all the arrangements. However, they can choose to opt out of pension saving. Although unless they are in significant debt or on a very low income, they should consider remaining in the scheme and getting into the savings habit early as by opting out they will lose the benefit of their employer’s contribution.'

How will it work?

WHAT ABOUT TAX?

Aviva's Lawson says: 'Saving into a pension is a tax-efficient way to save for the long-term as individuals not only get tax relief on their contributions, but their savings grow tax-free (although tax is levied on any dividends received from UK shares).

'In retirement, the income from the pension is taxed just like earnings, but also includes a tax free lump sum.

'Although there is no limit on the amount an individual can pay into their pension scheme, there is a limit on the amount of savings they can build up each year that benefits from tax relief. This is called the annual allowance and currently stands at £50,000 in any one year.

'If an individual’s pension savings for the year are more than the annual allowance then they will pay tax on the excess. However, this really affects people on a large disposable income who are making significant contributions. They include those that are highly paid, where the employer is making a substantial contribution or where they receive a large pay rise.'

The authorities want to ease people into the scheme gently so in the first four years, minimum contributions as a percentage of earnings will be just 2 per cent, made up of 0.8 per cent from workers, 1 per cent from employers and 0.2 per cent coming from tax relief.

All firms will eventually have to contribute at least 3 per cent of their employees' salary, with workers contributing 4 per cent, and 1 per cent coming from tax relief, making 8 per cent in total.

Workers would typically gain an extra £600 a year on top of their salary as a result of money paid by their employers into their pensions, the Government has calculated.

As an example:

John earns £12,000 a year (£1,000 a month before tax) and is paid monthly.

1. He pays in the equivalent of 4 per cent of his salary into his workplace pension (£40 a month). This is taken directly from his monthly pay.

2. His employer pays in the equivalent of 3 per cent of his salary (£30 a month).

3. The government, in the form of tax relief, pays the equivalent of 1 per cent of his gross salary (£10 a month).

So the total contribution to John’s pension pot is £80 a month.

How is my pension invested?

Most people don’t invest directly, but instead choose to invest in insurance or investment funds offered by their pension provider.

With fund investments, money is pooled with that of many other people, giving a choice of a much wider range of underlying investments at a lower cost than would otherwise be possible.

Lawson explains: 'The funds that people invest in tend to be of four main types: cash, bonds (or loans), property and shares. There are also funds which invest across these different types of assets, mixing together the risks and rewards and generally hoping to give the investor a smoother return.'

What are my other options?

You may choose to do this if you are self employed, or if you have opted out of a workplace pension.

With personal pensions you pay income tax on your earnings before any pension contribution, but the pension provider claims tax back from the government at the basic rate of 20 per cent.

In practice, this means that for every £80 you pay into your pension, you end up with £100 in your pension pot. If you pay tax at a higher rate, you can claim the difference through your tax return or by contacting HMRC. If you're an additional rate taxpayer you'll have to claim the difference through your tax return.

You may choose to top up your nest egg by paying into a personal pension because you like its investment options better than the one your employer offers. You will also need to claim the tax relief yourself here, whereas in a work scheme for basic rate taxpayers it is typically automatically done.

In reality it's unlikely that most would choose a personal solely over a workplace pension because you would miss out on employer contributions. You will probably also probably miss out on life cover attached to the pension and the potential benefit of lower charges.

You can usually top up your contributions into your workplace pension, although your company will only match up to a maximum amount.

SIPP versus stakeholder

Decisions: When and how to start pension saving

If you decide to go for a personal pension you will need to choose between a Self Invested Personal Pensions (SIPP) - which allows you to be more hands-on with your investments - and a stakeholder pension, the much simpler option.

Stakeholder

Stakeholder pensions were introduced in 2001 as a simple pension option which incorporates a set of minimum standards laid down by the government.

These standards are designed to make this type of pension simple, cheap and accessible for those on lower incomes.

As with most other types of defined contribution pension, the money can be drawn from age 55 onwards with a tax-free lump sum of up to 25 per cent taken straight away and the remainder used to buy an annuity.

Anyone aged under 75 can pay into a stakeholder pension and you can invest up to £3,600 each year.

SIPP

Generally accepted as an option for those who already have investment Isas and particularly for those who pay higher rate tax, SIPPs offer a much more flexible approach to investments.

That flexibility is the big plus point of this type of pension, but it does mean that the responsibility of picking the right funds is down to you.

You can invest in pretty much anything, from commercial property and gold bullion to more conventional unit trusts and shares.

When considering this as an option you need to ask yourself whether you are prepared to do the homework, and regularly monitor your investments.

Some people decide to invest via a stocks and shares Isa, which is much more flexible because your nest egg is not locked away until retirement - money can usually be withdrawn if needed at short notice, although you lose that element of your tax-relief allowance forever.

Payments into an Isa can also be as varied as your circumstances dictate, whether they are lump sums or regular investments.

Plus, not only is an Isa more flexible, it has the added advantage of not being subject to the whims of future governments, unlike pension rules, which chop and change constantly.

But this flexibility also means that your good intentions for saving for your old age might be blown away by the sudden desire to maybe upgrade your car a bit earlier than you otherwise would when you realise just how big a pot you've built up.

With an annual capital gains tax allowance of £11,000 investors can also make a hefty profit each year before they have to pay tax.

However, under the current system Isas protect the investments within from CGT and as many people invest for their future over the long term they may hopefully one day find themselves lucky enough to have a pot that would produce tens of thousands of profit if they cashed it in.

Higher rate taxpayers also get a more favourable treatment on dividend payments in an Isa than outside of such a wrapper.

One of the drawbacks to investing in an Isa used to be cost, as investing within one was markedly more expensive than doing so outside of one. In most cases this is no longer true, you may pay a bit more to invest in an Isa but not a lot.

You may decide to forgo pension saving altogether - or boost your retirement nest egg - by opting for a buy-to-let investment instead.

Essentially this means your money will be tied up in property, which will hopefully appreciate in value by the time you retire - although this is certainly not a given.

You can also put aside rent payments, or invest the money, which can add to your final savings pot.

There are a number of benefits to buy-to-let, but there are also downsides. Your property could depreciate in value, there will be maintenance and insurance costs and you may occasionally find yourself out of pocket - sometimes for months - if you don't find a tenant. You will be able to claim some of the costs back via tax relief.

With property, you also have the option of selling up or if it is your own home there is equity release at retirement. In a nutshell, equity release frees up capital in your property. There are many pitfalls, so equity release is not for everyone. Find out more about using this free guide.

What else do you need to know?

What if you have no extra cash and can’t save? Is there any point in putting away as little as £10 a month?

Lawson says: 'How much an individual saves into a pension is as important as having a pension in the first place. Saving too little could give a false sense that an individual is adequately preparing for retirement, when in reality their pension savings won’t be enough to meet their retirement expectations.

However, even modest savings can make a positive impact on someone’s comfort in retirement.

Those established in their careers should consider reviewing their pension pot annual statements and then comparing the income forecasts to what they think they will actually need in retirement.'

Should you set up a side business to save for your pension?

Lawson says: 'Those people who are on a very low income or who have significant debt may wish to consider whether saving into a pension is right for them.

'If they don’t feel they have enough available income to put money aside for the long-term then they may consider opting out of an automatic enrolment scheme. Taking a second job may be an option, but the individual needs to assess whether this is viable for them, and whether it would help them balance their short-term and long-term financial needs.'

Lawson says: 'Automatic enrolment does not include the self-employed which means that this group of workers needs to consider what pension arrangements they need to put in place for themselves, and whether for instance they should take out a personal pension, or if they want a wider investment choice, a self-invested personal pension (SIPP).

'The tax benefits are largely the same and so it pays for anyone that is self-employed to put some of their money aside into a pension.'